How Much Disabilitiy Insurance Should You Get?

Major Items That Affect Disability Insurance Premiums
If you buy your own policy, either as an individual or through a professional society group policy, your premiums will be reflect your occupation, age, sex, and the amount of income you wish to protect with insurance.  People in risky occupations will have higher premiums than those doing office work.

The length of the waiting period will also affect premium costs: selecting a longer waiting period reduces the cost.  If you have resources that you can tap in the early weeks of a disability, using a longer waiting period is a good way to reduce your costs.  Similarly, the duration of benefits (benefit period) will influence the cost: a policy that only pays for a few years will be cheaper than a lifetime-benefit policy.  In practice, most work disabilities aren’t lifelong.  If cost considerations are critical, a policy that pays benefits for 3-5 years might enable your household to get through a temporary disability.

It may be wise to get a policy that only pays until you retire, after which you’ll be entitled to Social Security benefits.  I’ve also heard it suggested that if you can buy a policy when you are younger and premiums are low, it could make sense to buy a policy with lifetime benefits.

Disability policies may offer cost-of-living benefits adjustments.  This feature will cost more but is a wise idea if a policy will be needed for many years.  Policies may also provide residual or partial disability benefits.  These provide a reduced benefit for situations in which disability results in a reduction in the amount of work that you can do but does not prevent you from working entirely.

How Much Disability Insurance Do I Need?
Answering this question is only a little less difficult than determining how much life insurance you need.

One of the first considerations is the fact that insurers typically limit the amount of disability insurance coverage that they’ll permit you to buy.  If people could buy a disability benefit equal to 100% of their salary, they would be more likely to do risky things (moral hazard) and some would be tempted to commit outright fraud. To reduce this danger, insurers typically limit the amount of coverage you can buy to about 80% of gross income.  If you’re a high-earner, the limit may be as low as 60%.

Disability benefits are normally taxable if your employer pays for the coverage, but they are received tax-free if you paid for the benefits yourself; if the cost is shared, the portion of coverage for which you paid is tax-free.  In determining the need for insurance, you must consider what portion of your benefit will be taxed.  If you earn $100K you probably get to keep less than $70K after taxes; a policy providing $70K in tax-free benefits would allow you to keep spending as if you weren’t disabled.

During a disability, you’ll need to pay for whatever would normally be paid from your salary.  If you’re currently spending all your take-home pay, you’ll need at least that much after taxes or you’ll need to change your lifestyle.  Maintaining health insurance will be critical; if your disability requires medical treatment and you don’t have health coverage, your costs could balloon enormously.  Assuming that you’ve calculated your waiting period to allow for spending emergency savings at the outset of disability, you should try to have enough disability coverage to pay for expenses that continue during disability: housing, food, car payments, regular monthly expenses, etc.

You won’t be paying into a retirement savings plan while you’re disabled and if you have no earned income, you won’t be able to save money into an IRA, so you won’t have those expenses.  However, if you’re a high-earner and have expensive life goals that assume that your income will continue, you probably need to consider forms of insurance that could make up for lost retirement saving in the event of a major disability.

About the author

Thomas Fisher, CFP®

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